Currency: An Alternate View to a Collapse

The Chinese have approximately $2,000,000,000,000 (that's trillion) in foreign exchange reserves. About half of that is held in U.S. government bonds with the remainder held in other currencies (euros, rubbles, etc.). The popular theory goes that China cannot afford either the default or a significant weakening of the U.S. dollar as it would batter it's own currency, the renminbi, and the savings of its citizens. One of my own professors, who will remain nameless, taught his students that the U.S. and China were reliant on each other and that China simply could not afford to de-couple from the United States because of the resulting damage to renminbi. He told us that we were trapped in a spiral of U.S. trade deficits and foreign direct investment by China that would never end. Americans could keep buying cheap Chinese manufactured goods with money lent to us by the Chinese themselves. The party will never stop. 

I'm not trying to fault the professor. Far from it. What he taught us was, and still is, the prevailing wisdom by a long shot both on Capitol Hill (where he worked) and on Wall Street. Only the morally upright Austrian School economists, such as Peter Schiff, think that China will "pull the punch bowl" and that this will be done for moral, not monetary, reasons. I have an alternative view.

Let's run a quick theoretical scenario: the U.S dollar plunges by 25% over the course of a month. What happens to renminbi? Conventional wisdom says that, because the Chinese do not float the renminbi and the renminbi is backed by large dollar denominated assets, the renminbi will fall in concert with the dollar. This mode of thinking, however, does not take into account what the Chinese might do in reaction to the dollar's decline. If the Chinese were to float the renminbi, make it fully convertible, and relax capital controls.... the renminbi would soar. Or at the very least retain its value. This would happen because investors would seek the renminbi as a safe haven, as a reserve currency, and possibly as a currency of settlement. Capital inflows from foreign governments and private investors would likely counter any decline in Chinese owned U.S. government debt. 

The counter argument to this is that the Chinese government could not afford such appreciation of the renminbi because it would obviate one of its advantages in trade, an artificially weak currency, and the resulting unemployment from such currency appreciation would be politically unacceptable. The point that is missed here is that, under the prior scenario, the renminbi would only appreciate against the dollar, not (necessarily) other currencies as the prevailing wisdom suggests. Just as capital would seek the renminbi, it would also seek currencies of China's trade partners (Euro, Yen, etc.) Thus only a portion of China's exports, perhaps $80 billion, would be affected. The domestic economy, which would suddenly find itself richer, could soak this up easily. There might be a short term spike in Chinese unemployment but would not be long lived. 

The result? China would suddenly find itself a lot richer and the U.S. would suddenly find itself a lot poorer. Economic justice I suppose, for it is productive capacity that backs one's currency and determines the wealth of one's nation and nobody can argue with China's productive supremacy in today's economy. 

Edit: I stumbled upon this article on the Financial Times' website . What would China need if it were to float the renminbi? Swap lines with other foreign central banks and a stock of commodities to tide it over until the dollar was no longer the primary settlement/pricing currency. Turns out I don't have such an "alternative" view after all. It has begun.